The Real Question Facing Stocks

When we boil it down, the question on all of our minds is simple: Can stocks keep going up?

There are any number of variables we can look at when it comes to evaluating what the market may or may not be able to do -- unemployment, consumer confidence, credit market conditions, economic projections … the list goes on and on. But I think the most important variable right now may be valuation.

As Berkshire Hathaway's (NYSE:BRK-A) Warren Buffett has put it, "Price is what you pay. Value is what you get." And when I look at the market as a whole, I'm not so sure that the getting is good right now.

If only it were like the '70s
When it comes to the stock market, history is hardly a perfect predictor (if it were, then Long Term Capital Management never would have imploded), but it can help us put today's situation in context.

When evaluating the market's valuation, one of my favorite tools is the dataset that economist Robert Shiller has put together, which tracks the market's price against inflation-adjusted average 10-year earnings. The data is great, because not only does it stretch back to the late 1800s, but by using average 10-year earnings, it also smoothes earnings over economic cycles.

The average 10-year earnings multiple for the market over Shiller's entire dataset is 16.3. Here's a look at valuations at various points in the past:

Source: Robert Shiller, irrationalexuberance.com. Market bottoms and peaks defined by monthly composite average in 1930s.

It's pretty easy to see that the valuations we're looking at today are much higher than what were available in the past. In fact, though the average 10-year P/E over Shiller's dataset is 16.3, the average over the past 20 years has jumped to 25.9.

OK, but why?
One of the primary reasons for this likely lies in "The Great Moderation," a phrase coined by Harvard economist James Stock. The Great Moderation refers to the idea that starting some time in the 1980s, macroeconomic volatility declined substantially, creating a more reliable environment for business and investing.

In a 2004 speech, Fed Chairman Ben Bernanke suggested that The Great Moderation was brought about by structural change (i.e., improvements in banking, technology, business practices, and the like), better macroeconomic policies (a pat on the back for the Fed), and simply good luck.

The impact of The Great Moderation for investors was that, supposedly, they could count on these factors to keep macroeconomic volatility under wraps, and therefore expose their investments to less risk. And if we look at most valuation models, less risk means that you can accept a higher valuation.

But the Fed has also played a more direct part in padding valuations. While risk is one input for most valuation models, the "risk-free return rate" -- usually based on U.S. Treasury bond yields -- is another. Going back to 1955, the average effective federal funds rate has been around 5.6%. Since 1990, that average has dropped to 4%.

Investors are always looking at the trade-off of where they can get the best returns, so when the returns on stocks' competition -- bonds in this case -- fall, they're willing to pay more for stocks.

But can it last?
Certainly, the current environment lends itself very well to shopping in the stock aisle in the investment superstore. With the federal funds rate targeted at between 0% and 0.25% and 10-year Treasuries promising just 3.48%, stocks don't have a very high returns bogey to overcome.

Currently, stocks like AT&T (NYSE:T) and Chevron (NYSE:CVX) pay higher dividends than the Treasury yield. On the basis of current earnings yield -- which is the inverse of P/E -- even seemingly higher valued stocks like Cisco (NASDAQ:CSCO) and Research In Motion (NASDAQ:RIMM) beat the bond bogey.

But the problem is that it's all unsustainable. Unless the Fed wants to help along Buffett's prediction about a crash in the dollar and the U.S. becoming some sort of banana republic, it's going to have to increase rates well above their current levels. As for the disappearance of risk, well, I'm sure folks like Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) have taken a long hard look at how they appraise risk in their models.

The bottom line is that investors are going to start realizing that valuations that may have seemed cheap in 2006 or 1999 are no longer acceptable. And when that happens, there will be one group of investors who will be able to navigate that seemingly new world -- those who really know the difference between price and value.

Think I'm nuts? Think all stocks are still too cheap to pass up? Scroll down to the comments section and share your thoughts on valuation.